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Factor Investing
Kerry Back

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Quantitative Investing
Kerry Back

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Factors
- Quantitative investing means investing based on quantifiable characteristics
- Stock characteristics that predict returns are sometimes called factors. Examples:
- value (cheap relative to book, earnings, …)
- momentum (high past return)
- liquidity (high volume, low bid-ask spread, …)
- volatility
- quality (profitability, high cash flow to income, …)
Sorts on characteristics 
- Sort into quintiles or deciles
- Equally weighted or value weighted return of each group
- Re-sort at the beginning of the next period
- French’s data library: monthly sorts and returns
Investing in multiple factors
- How best to combine factors?
- Could sort on factors separately and intersect sorts
- Example: quintiles and 2 factors \(\Rightarrow\) 25 groups
- Quintiles and 5 factors \(\Rightarrow\) 3,125 groups. Many will be empty.
- Could form portfolio for each factor and equally weight
- Could combine factors to predict returns and then sort on predictions
Market efficiency
- The Efficient Markets Hypothesis is that it is not possible to earn extra returns without taking on extra risks.
- Factor investing can be profitable even if markets are efficient.
- The returns to factors may be risk premia.
- Some investors may not be as averse to some risks as others are, so they should pick up the risk premia.